Tuesday, August 16, 2011

On investment and taxes

To follow up on Matias' last post, with all of this talk about taxes and job creators, it is worth thinking through the effects of taxes on the decision by firm to invest in new plant and equipment (thus creating jobs). Thinking through the baseline scenario, it is not immediately obvious why a capital gains tax (or even a profits tax) would discourage investment. The investor (firm) only gets taxed on gains (profit) so unless the tax is 100 per cent, they still make money. It would be hard to find a successful businessman who chooses not to make money! Of course, other costs may imply that the world is a little more complicated.

In addition, it is well known in the empirical literature on investment that the decision by to firms to expand productive capacity is quite insensitive to the cost of capital and quite sensitive to current and expected demand for the firm's output. Taxes, along with interest rates, the price of equipment, and other items form the total cost of capital. Thus, taxes are a (small) component of a group of costs that really don't matter!

Not only that, but if the taxes are on capital gains, they matter even less! In general, firms finance investment out of retained earnings first, loans second, and issuing new equity third. That is, the stock market is the last resort in paying for new plant and equipment. This is because issuing new shares may dilute the value of existing shares, and may signal to markets that the firm doesn't have the ability to finance investment out of profits and can't get a loan. So firms are particularly insensitive to stock markets! This suggests the very often, the stock market is but a sides show - a very large casino that has little to do with productive investment.

Finally, if it is the case that investment is pretty I insensitive to taxes (particularly those on capital gains) and the tax revenues are spent on the output firms (perhaps via unemployment insurance or welfare payments), we may have a large "balanced budget multiplier." In other words, we end up taking savers and transferring it to spenders, thus encouraging economic expansion. It is then likely the case that taxing the "job creators" actually creates jobs!